I recently had the pleasure of speaking to David Green, the CEO of Harvard Apparatus Regenerative Technology (HART). Please listen to that interview here either before or after reading this, as it supplements the content of this article. This company is pre-revenue, so it is not one that I would typically invest in or value. However, I am open to all investment ideas, and this one has a few important exceptions that made me pay attention. Notably, the company has demonstrated proof of concept, holds numerous patents, and is the first mover in a $600 million market all while sporting a tiny market cap.
HART was recently spun off of Harvard Bioscience (NASDAQ:HBIO). The company is currently working to attain regulatory approval of its first product, the InBreath System. The InBreath System uses a porous plastic scaffold and a bioreactor to grow tracheas that are ready for transplant into patients with trachea cancer and other tracheal damage. The scaffold is seeded with the patient's own stem cells, so there is no risk of rejection. Therefore, there is also no need for expensive anti-rejection drugs. The company is currently targeting approval in Europe by the end of 2015 and in the US by the end of 2016.
The InBreath System has shown a great deal of promise. Ten patients have received trachea transplants so far and eight are still alive today. The two deaths were unrelated to the transplant. It is important to understand that these ten patients received their transplants on a compassionate use basis, meaning that their conditions had become so dire that the trachea transplants were used as last ditch efforts to save their lives.
With that understanding, it is less surprising that two patients had, unfortunately, passed away and much more surprising that eight have actually survived. Of those eight, one patient is currently a five-year survivor, another is a three-year survivor, and the rest are around one year. Take note that the median survival for those inflicted with trachea cancer is a mere ten months.
Also worth mentioning is that the five-year survivor did not receive a synthetic scaffold. She received a donor trachea that was cleansed of the donor's cells and reseeded with her own stem cells. However, her transplant and subsequent survival are still relevant to this discussion. In fact, it highlights the value of the complete system, because donors are not needed when synthetic scaffolds are used.
HART benefits as the first mover in this type of transplant. The company holds numerous patents, most of which are in effect until 2030-33. In addition to patent protection, HART could benefit from orphan legislation that would grant the company an additional seven years of exclusivity in the U.S. and an additional ten years of exclusivity in the E.U. The company estimates that 6,500 new patients are in need of trachea transplants each year due to trachea cancer, trachea trauma and tracheal agenesis. That would make the potential market over $600 million annually if they are able to charge $100,000 per procedure.
Finally, tracheas are only the beginning. The next logical step, according to David Green, is the esophagus. The company has also done some early work involving lungs, heart valves, and hearts. It will be many years before the latter are being transplanted into humans, but the potential is real and has been demonstrated in the lab and in mice.
A Special Situation Investment
HART fits the Greenblatt-style spinoff opportunity perfectly. Post-spin it is a company that very few funds, if any, are likely to hold. It is a micro-cap that has no revenue, so it is way too small and speculative for institutional holders. That was evidenced by the selling pressure in the days following the spin.
Another interesting aspect of this spin, which Greenblatt would also appreciate, is David Green himself. Mr. Green served as President of Harvard Bioscience, HART's parent company, for 17 years. Being a top executive at a $130 million company is a safe bet. Yet, he chose to leave his executive position at Harvard Bioscience to become the CEO of the much smaller Harvard Apparatus Regenerative Technology. That's the kind of faith that I like to see in a leader.
Security analysis does not seek to determine exactly what the intrinsic value of a given security is. It needs only to establish either that the value is adequate… to justify a stock purchase-or that the value is considerably higher or considerably lower than the market price… To use a homely simile, it is quite possible to decide by inspection that a woman is old enough to vote without knowing her age or that a man is heavier than he should be without knowing his exact weight. -Ben Graham
Ben Graham made the point that intrinsic value is not an exact science. Saying what a company is worth down to the penny is ludicrous. A variety of numbers can be justified at any given point in time for any company. However, value, or the lack thereof, is easier to spot in extreme situations. I feel that this is one of those extremes. I am confident that this company will be worth more than $40 million in the future. Despite my gut feeling, I have still attempted to value HART mathematically.
Honestly, I was not sure if the numbers would agree with my instinct when I began. Be mindful that one has to wear an optimist's hat when valuing a company like this. The valuation must be based on an objective opinion of what the company could reasonably become. If that sounds like wishful thinking to you, I might have agreed if it weren't for the InBreath System's successes with fragile patients. Therefore, I believe, it is not a question of if but of when in regard to final regulatory approval.
While valuing HART, I assume that the company will receive approval in Europe by the end of 2015 and approval in the U.S. by the end of 2016, as the company currently expects. Realizing that growth takes time, I assumed that the company would capture only a small portion of the market by 2017, so I pegged that number at 3%. I further assumed that they would be able to ultimately capture 50% of the market by 2023. The potential market should grow at 1% per year, which is the expected rate of worldwide population growth over that time.
Next, I assume that the company will begin to borrow debt when it is capable of doing so. As a result I have built debt levels into the spreadsheet that increase from 5% to 20% between 2017 and 2023. 20% is the industry average. The industry in this case is invasive medical supplies.
This industry includes well-known companies like St. Jude (NYSE:STJ), Medtronic (NYSE:MDT), Boston Scientific (NYSE:BSX), Intuitive Surgical (NASDAQ:ISRG), etc. I found that companies in this industry generate $1.55 to $1.75 in sales for every dollar of capital invested. I estimated HART's reinvestment needs using a 1.6 sales/capital ratio.
I then estimated the value of 2.1 million options outstanding and subtracted that from the equity value of the company. This may need revision as more information is released in future quarters, but, while important, it does not drastically alter the outcome. The price per share is listed on the basis of 8 million common shares currently outstanding. This will almost assuredly increase in the coming years, but the negative cash flows build future capital needs into the valuation.
The average operating margin for a company in this industry, excluding outliers, is around 10%. It is 15.9% for the more successful companies. As it turns out, the margin assumption is the largest driver behind this valuation. Plugging in a 10% margin resulted in a price per share of $6.21. However, it is easy to imagine HART's operating margin being closer to its more successful peers given its intellectual property and niche focus. To that end, a 15% margin resulted in a price per share of $16.66.
I stated previously that valuing a company to the penny is ludicrous, and it is. I cannot say with absolute certainty that the company is worth $6.21, $10, $16, or any other number. However, if you believe, as I do, that the above assumptions are reasonable then the company appears to be undervalued regardless of the magnitude of the discrepancy, which could be modest or great.
To conclude, I believe that HART represents a good value for long-term shareholders who understand the risks involved. The greatest risk here is a significant regulatory delay. Such a delay would cause the company to generate operating losses further into the future. However, early successes of the InBreath System bode well for the company. Furthermore, this valuation is based solely on the potential of the InBreath System and does not account for any future innovation involving other organs. Thanks to the company's current market cap and stage of life, HART potentially represents an opportunity for smaller investors to get in at a price that large institutions cannot.
If you'd like to download the spreadsheet I used for this valuation click here.
Disclosure: I am long HART. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.